A Critical Analysis of the Malaysian Risk-Based Capital ... · A Critical Analysis of the Malaysian Risk-Based Capital Framework: A Comparison between General Insurance and Takaful

Institutions and Economies

Vol. 8, No. 4, October 2016, pp. 23-41

A Critical Analysis of the Malaysian

Risk-Based Capital Framework: A

Comparison between General Insurance

and Takaful

Aida Yuzi Yusofa, Wee-Yeap Laub, Ahmad Farid Osmanc

Abstract: This paper aims to critically analyse the Malaysian solvency system by

comparing the existing Risk-Based Capital (RBC) framework for Conventional and

Takaful against the seven specific objectives of the original US Risk-Based Capital which

was introduced in 1994. In addition, the Malaysian Risk-Based Capital framework is also

assessed against the four extended objectives developed by Holzmüller in 2009. The

critical evaluation results indicate that the Malaysian Conventional and Takaful Risk-

Based Capital frameworks have various shortcomings from both qualitative and

quantitative aspects. The framework only fully meets three out of seven objectives of the

US Risk-Based capital framework and fulfils one out of four additional objectives

developed in 2009: Malaysia’s Risk-Based Capital framework only fulfils the following:

the appropriate incentive for capital expansion, measurement of economic values of assets

and liabilities, sound financial reporting and assessment of management. As a

consequence, it is clear that the current one-size-fits-all approach must be reviewed to

improve the Malaysian RBC Framework in view of different sizes and assets of existing

firms in the industry.

Keywords: Insurance supervision, risk-based capital, risk management, takaful

JEL classification: G2, L5, O2

Article received: 13 October 2015; Article Accepted: 25 September 2016

1. Introduction

As an important component of the evolving financial services industry,

insurance is one the most regulated industries in the Asian region. Likewise,

in Malaysia, the insurance sector is under the purview of Bank Negara

aCorresponding Author. Department of Applied Statistics, Faculty of Economics and Administration,

University of Malaya, 50603, Kuala Lumpur, Malaysia. Email: [email protected] b Department of Applied Statistics, Faculty of Economics and Administration, University of Malaya,

50603, Kuala Lumpur, Malaysia. Email: [email protected] c Department of Applied Statistics, Faculty of Economics and Administration, University of Malaya,

50603, Kuala Lumpur, Malaysia. Email: [email protected]

24 Aida Yuzi Yusof, Wee-Yeap Lau, Ahmad Farid Osman

Malaysia (BNM). However, due to its dual business models i.e. the

Conventional Insurance and Takaful, both entities fall under different laws.

The Conventional Insurance is regulated under the Malaysian Insurance Act

(1996) while the Takaful is regulated by the Malaysian Takaful Act (1984).

Basically, the law provides for licensing and regulation of insurance

businesses such as insuring broking business, adjusting business and other

related purposes. According to Lai (2011), in order to maintain stability and

financial soundness of the insurance industry, BNM has adopted a risk-based

supervision approach for insurers including Takaful. Risk-based supervision

involves the regulatory authorities who focus on aspects of the financial

system which cause the greatest risk to its stability. The nature and level of

supervisory activity of insurance are conducted by profiling risk and

assessment of risk management. By focusing on risks, BNM can detect

potential risks that will jeopardise the stability of the financial system.

Through the regulatory and surveillance units of BNM, practice note,

guidelines and standards that cover various aspects such as valuation of

assets and liabilities, solvency regulations, risk management practices were

introduced as part of the legal framework to provide guiding principles in

monitoring insurance and Takaful companies. Ensuring insurers’ solvency

has always been a focal point of regulation, and BNM uses various methods

to promote insurers' financial strength and protect policyholders from losses

due to insolvency.

At present, the literature on the effectiveness of the Malaysian Risk-

Based Capital is scarce. Risk-Based Capital (RBC) is defined as the

minimum amount of capital that an insurer should hold based on the degree

of risks it bears to protect its customers against adverse development.

Generally, the risk-based capital model is a factor-based model which

aggregates the chosen risk types that are faced by insurers. A single number

is then produced to represent the capital level required to cushion against

unexpected losses of insurers. An interesting fact about the Malaysian

insurance industry is that since the implementation of Risk-Based Capital

framework, there has been no case of regulatory action reported. Certainly,

there has not been any worst case of insolvency reported. This could be

attributable to Malaysia’s strong institutional framework related to its

financial sector as Malaysian life and general insurers have a strong financial

condition with Capital Adequacy Ratio way above the supervisory level of

130%. Despite this, a study done by Yakob, Yusop, Radam, and Ismail

(2012) shows there could be potential risk as they found three insolvent

companies detected under the CAMEL approach.

On the other hand, studies from US Risk-Based Capital provide a

different view. According to Cummins, Harrington, and Klein (1995) and

Lin, Lai, and Powers (2014), risk-based supervision does not guarantee the

soundness and safety of the insurers’ financial condition. Cummins et al.

A Critical Analysis of the Malaysian Risk-Based Capital Framework 25

(1995); Cummins, Grace, and Phillips (1999); Cummins and Phillips (2009)

and, Cheng and Weiss (2012) state that US RBC is not a good predictor of

insolvency. In addition, Lin et al. (2014) claim that US RBC regulation is

ineffective in ensuring poorly capitalised insurer to limit its risk taking; it is

worsened by US RBC regulation inability to intervene and take corrective

measure. Thus, this brings into question how effective is the Malaysian

Risk-Based Capital and what makes it so different from US Risk-Based

Capital, of which BNM used as a foundation to develop its own solvency

framework. Therefore, determining the factors that contribute to the financial

strength of Malaysian insurers is vital.

This study aims to analyse the Malaysian RBC framework against seven

objectives set by Cummins, Harrington, and Niehaus (1993). They had

developed the first conceptual framework to evaluate Risk-Based Capital

criteria that can be used by different stakeholders of insurance company. The

Risk-Based Capital standards are based on an analytical review of an

insurer’s insolvency risk and outlines major principles and purposes behind

the solvency regulation. In addition to the seven (7) criteria set by Cummins

et al. (1993), the Malaysian Risk-Based Capital is analysed against additional

objectives proposed by Holzmüller (2009). This is to cater to current changes

and trends involving the insurance market that has become more risk-

sensitive.

This paper contributes to the extant literature by reviewing critically the

Risk Based Capital Framework in order to improve the Malaysian solvency

system, namely its regulation and supervision, for the benefit of all

stakeholders. The rest of the paper is outlined as follows. Section 2 provides

review of main literature on Malaysian Risk Based Capital framework,

Section 3 assesses the Malaysian Risk Based Capital framework against the

objectives set by Cummins et al. (1993) and Holzmüller (2009) while Section

4 provides findings of the assessment. The final section concludes the paper.

2. Literature Review

2.1 Development of Risk-based Capital

The solvency regulation consists of requirements related to reserves,

restrictions on investment and capital and other financial matters. Among

these, capital requirement receives significant attention as solvency concerns

the minimum capital requirement. In the past, regulatory requirement on

capital is just a fixed minimum amount of capital. This approach has been

adopted by many countries such as Solvency I for European Union in 2002,

Thailand in 2007 and Singapore in 2010. In Malaysia, the traditional capital

adequacy requirement is formerly known as the margin of solvency which

came into effect in 2006. The fixed minimum amount of capital or better


known as “one-size-fits-all” approach has evolved and been implemented

around the world, but few studies have been conducted into its effectiveness.

Cummins and Phillips (2009) report that EU Solvency I does not consider

the risk differences among lines of insurance while Pichet (2007) finds that

the traditional approach does not reflect asset allocation and asset mix of an

insurance company and does not reward good risk management practices

undertakes by an insurer. To date, the traditional approach becomes

irrelevant due to these reported weaknesses. With the advancement of capital

adequacy regulation, a new risk-based capital requirement was developed.

The development of risk-based capital requirement was initiated by

Canada in 1985 and followed by the US in the 1990s. Since then, this new

risk-based capital adequacy requirement continues to evolve as it could

address the risk profile of insurance companies compared with the previous

traditional approach. In Southeast Asia, the first country that implemented

the risk based capital requirement was Indonesia in 1999, followed by

Singapore in 2004. In Malaysia, the Risk-Based Capital framework for

conventional insurer was launched in 2009 while the Takaful Risk-Based

Capital framework was introduced in 2014. Meanwhile, European Union

applied the fixed minimum amount of capital by replacing Solvency I with

Solvency II in 2012.

Over the years, the risk-based capital model has proven to be the most

popular method in identifying insolvency cases. Many studies predicted

insolvency of insurance companies using Risk-Based Capital ratio (Grace,

Harrington & Klein, 1993; Cummins et al., 1995; Cheng & Weiss, 2012)

while some studies compared Risk-Based Capital models with previous

solvency systems (Bratton, 1994; Holzmüller, 2009). Pottier and Sommer

(2002) compared the accuracy of various Risk-Based Capital models while

Cummins et al. (1999) developed a new approach in determining risk-based

capital.

Cummins et al. (1993) developed an economic overview of Risk-Based

Capital requirements with the objective to provide a conceptual framework

for policymakers. This concept is set as a benchmark for the policymakers to

analyse their Risk-Based Capital framework. There are seven objectives to

be fulfilled where any Risk-Based Capital framework should provide

incentive for weak companies and able to identify the highest cost company.

Furthermore, the framework should have a mechanism for any misreporting

of the document and the formula for capital adequacy under the framework

should cover and proportioned to major risks, reflects economic value and

be as simple as possible.

Doff (2008) analyses the Solvency II with respect to the work of

Cummins et al. (1993) while Holzmüller (2009) also reports a thorough

evaluation on the Solvency II, US Risk-Based Capital and Swiss Solvency

Test against the same criteria. Based on the analysis, Doff (2008) concludes


that Solvency II satisfied most of the criteria. The same conclusion is also

drawn by Holzmüller (2009). Despite that, US Risk-Based Capital also fails

in most of the other criteria. Among its weaknesses are:

i. The Risk-Based Capital formulation rewards insurer that holds

lower reserves, which could lead to a reduction in capital

requirement and a higher insolvency risk;

ii. The US Risk-Based Capital is not risk sensitive as capital charges

do not reflect the risk of business written;

iii. The US Risk-Based Capital does not work in the stochastic nature,

imbalance weighted capital requirement and omit any correlation.

Its time horizon for property & liability is one year, which does not

take into account the long term claims and Incurred but Not

Reported claims (IBNR);

iv. The Risk-Based Capital requirement is not dependent on the risk

assessment of insurer but the size of the company; and

v. The US Risk-Based Capital adopts a factor-based approach with the

application of historical statutory value instead of net-worth or

market value.

Compared with Solvency II and Swiss Solvency Test, the calculation of

individual risk charges is simpler even though it requires a longer data set.

In addition, Holzmüller (2009) adds four more criteria to reflect current

economic conditions and advancement in the global insurance industry. First

objective relates to the adequacy of capital in economic crises and

anticipation of systemic risk: Solvency regulation should anticipate systemic

risk and prevent the insurance industry from being trapped in a vicious cycle

when economic crises occur.

Next is the assessment of management: A solvency system should take

into consideration ‘‘soft’’ factors which include management capabilities.

The third objective is on flexibility of framework over time: A model should

be flexible with regards to its general concept and to its parameters.

Empirical insights and theoretical development, such as new models and

concepts should lead to continuous improvement. The final objective is to

strengthen the risk management and market transparency: Solvency

regulation should require insurers to handle the predominantly quantitative

risks with sound risk management. Increased market transparency will, in

the long run, reduce the need for regulation. Again, US Risk-Based Capital

fails the additional criteria. The advantages that Solvency II and Swiss

Solvency Test possess compared with Risk-Based Capital are the use of

internal model (fits the insurer risk profile), the estimation of asset and

liability based on market value, and public disclosure that foster market

transparency.


So far, there has been no study done that reviewed the Malaysian RBC

against the conceptual framework set by Cummins et al. (1993). However,

there are few studies on the solvency issue of insurance companies in

Malaysia. Yakob et al. (2012) measured the soundness of conventional and

Takaful operators using Risk-Based Capital, margin of solvency and claim

paying ability of Rating Agency Malaysia. Data from 22 insurance firms

from 2003 to 2007 were collected and analysed using balanced panel data

and generalised least square model. The study concluded that insolvency was

not a major problem for life insurers. Yakob et al. (2012), assess the insurer’s

financial strength using the CAMEL approach on 20 life insurers and Family

Takaful operators from 2003 to 2007 and detected 3 insolvent companies.

Likewise, Chiet, Jaaman, Ismail, and Shamsuddin (2009) applies Artificial

Neural Network to create an early warning system for solvency prediction

and find that the model can be used predict insolvency. According to Ismail

(2013), solvency margin has a negative and significant effect on the

performance of general insurer and Takaful operators. All these results show

that Malaysian Risk-Based Capital framework is effective at preventing an

insurance company from becoming insolvent.

2.2 Malaysian Risk-Based Capital Framework

2.2.1 Conventional risk based capital

Risk-based capital is defined as the minimum theoretical amount of capital

based on the degree of risk taken by an insurance company that an insurer

should hold to protect customers against adverse developments. Generally,

the risk-based capital model is entirely factor-based model which aggregates

the chosen various risk types faced by insurers. A single number is then

produced to represent the capital level required to cushion against

unexpected losses of insurers.

The Risk Based Capital (RBC) Framework for conventional insurers

introduced in 2009 by Bank Negara Malaysia (BNM) concentrated on

financial risks such as credit, market, underwriting and concentration risk.

As the insurance industry is evolving and moving to a developed market, the

RBC framework needed a revamp in terms of risks which were not specified

by the earlier framework. Thus, in 2011, BNM introduced the enhanced RBC

framework with broad risks to be managed. Based on the documents issued

by BNM, the revised RBC focuses on credit risks (assets default and failure

of counter-party), market risks (reduction in assets market value and non-

parallel in asset-liability), liability risk (insurance liabilities underestimation

and adverse claims experience) and operational risk (failed system and

human capital process). According to Frenz and Soualhi (2010), the

principles of the framework are as follows:


Figure 1: The principles of risk based capital

Source: Frenz & Soualhi (2010).

2.2.2 Takaful risk based capital

Takaful Malaysia was established in 1984 wherein it first introduced Islamic

insurance (Takaful) in Malaysia. Currently there are 15 Takaful operators in

Malaysia. In 2010, new operational and valuation guidelines were issued in

order to improve the Takaful regulatory framework. Further, in 2011, the

first draft of Risk-Based Capital Guidelines for Takaful Operators was issued

and took effect on 1 January 2014. This framework is part of a requirement

for solvency under the Islamic Financial Services Board (IFSB) “Standard

for Solvency Requirements in Takaful Undertakings” (E&Y, 2012). The

RBC for Takaful Operators is similar to its counterpart in the following

areas:


i. BNM imposes 130% minimum supervisory target capital level or

Capital Adequacy Ratio (CAR) to assess the financial strength at an

operational level.

ii. The management of Takaful operators must set an individual capital

level target that matches the risk profiles and risk management

practices. The dividend pay-out is available if the target capital level

is achieved.

iii. Similar to a conventional insurer, the risk-adjusted capitalisation or

the available capital is based on Tier 1 and Tier 2 categories

(Odierno, 2010).

iv. The main difference of Takaful from conventional RBC is the

introduction of “qard” or interest-free loan from the Shareholder’s

fund in any event of shortage in the Participant’s Risk Fund (PRF).

This would enable the PRF to meet its obligations.

2.2.3 Capital adequacy ratio

Each insurance company and Takaful operator is classified based on Capital

adequacy Ratio (CAR) which is expressed as:

𝐶𝐴𝑅 = 𝑇𝐶𝐴

𝑇𝐶𝑅

Where TCA is total capital available and TCR is total capital required.

The TCA comprises total equity whereas TCR is the sum of credit risk capital

charges, market risk capital charges, insurance liability risk capital charges

and operational risk capital charges. These charges must be determined at a

funding level. The CAR is used to assess the financial strength with BNM

imposing a minimum supervisory target capital level of 130%. The same

methodology and assumptions as outlined in the RBC requirements for

conventional business have been used to determine each of these capital

charges which were drafted for Takaful business.

Figure 2 illustrates the Malaysian Risk Based Capital Framework for both

Conventional and Takaful Operators. Based on Figure 2, the risk based

capital adequacy ratio consists of total capital required (TCR) and total

capital available (TCA). There are four capital charges under TCR. Credit

Risk Capital Charges (CRCC) aims to mitigate risk of losses resulting from

assets default and related loss of income, and the inability or unwillingness

of a counter-party to fully meet its contractual financial obligations. Market Risk Capital Charges (MRCC) aims to mitigate risks of financial losses

arising from the reduction of market value of assets and the non-parallel

movement between the value of liabilities and the value of assets backing the

liabilities due to interest rate movement.


Figure 2: Malaysian risk based capital framework

Notes: CRCC-Credit risk capital charges, MRCC-Market risk capital charges, LRC-

Liability risk capital charges and ORCC-Operational risk capital charges.

Liabilities Risk Capital Charges (LRCC) aims to address risks of under-

estimation of the insurance liabilities and adverse claims experience

developing over and above the amount reserves already provided related to

claims or unexpired risks. The RBC is currently setting the actuarial

computation at the 75% level of confidence. Operational Risk Capital

Charges (ORCC) aims to mitigate the risk of losses arising from inadequate

or failed internal processes, people and systems.

3. Framework of Analysis

This section discusses the criteria used to assess the Malaysian Risk-Based

Capital framework. This paper uses the criteria established by Cummins et

al. (1993) and further compares the Malaysian Risk Based Capital

framework with additional criteria set by Holzmüller (2009).

3.1 Risk Based Capital Assessment Framework

According to Cummins et al. (1993), “a well-designed risk-based capital

system must achieve an appropriate balance among a number of specific objectives related to risk measurement and market responses to risk-based

capital requirements”. The Risk Based Capital formulation should be closely

reflecting the outcome of competitive market when asymmetric information

is available. Our goal is to evaluate the Malaysian RBC and assess the

advantages and disadvantages of the framework according to specific

objectives set as follow:

Objective 1: The risk-based capital formula should provide incentives

for weak companies to hold more capital and/or reduce

their exposure to risk without significantly distorting the

decisions of financially sound insurers.


Objective 2: The risk-based capital formula should reflect the major

types of risk that affect insurers and be sensitive to how

these risks differ across insurers.

Objective 3: The risk-based capital charges (or weights) for each major

types of risk should be proportional to their impact on the

overall risk of insolvency.

Objective 4: The risk-based capital system should focus on identifying

insurers that are likely to impose the highest risk of

insolvency.

Objective 5: The formula and/or the measurement of actual capital

should reflect the economic values of assets and liabilities

wherever practicable.

Objective 6: To the extent possible, the risk-based capital system

should discourage underreporting or loss of reserves and

other forms of manipulations by insurers.

Objective 7: The formula should avoid complexity that is of

questionable value in increasing accuracy of risk

measurement.

Holzmüller (2009) added four more objectives to the universal Risk Based

Capital objectives. The aim was to capture the dynamic relationship between

the financial players in capital markets.

Objective 8: Adequacy in economic crisis and anticipation of

systematic risk.

Objective 9: Assessment of management.

Objective 10: Flexibility of framework over time.

Objective 11: Strengthening risk management and market transparency.

The following section reports the findings of this paper.

4. Findings

The assessment of the Malaysian risk based capital against the 11 objectives

established as the criteria is as follows:

4.1 Provide Incentive for Weak Companies

One of the Risk-Based Capital goals is to provide incentives for weak

insurers to hold more capital or to reduce risk exposure when their financial

state is at stake (Holzmüller, 2009). Policyholders, in order to protect their

interest, demand insurers to hold more capital to avoid insolvency. However,


the increase in capital hold should be parallel to increase in risk exposure,

based on theory of risk and capital (Merton & Perold, 1993).

The Malaysian Risk-Based Capital fulfils this objective of appropriate

incentives. Each capital charge will be calculated based on risk charges set

by Bank Negara Malaysia which allows the increase of capital requirement

based on the increase in exposure of risk. For example, the liability risk

charge is applicable on both claim liabilities and premium liabilities where

the risk charges for marine, aviation and professional liability (high severity

risks) are determined by the highest value (45%). According to Cummins et

al. (1993), the RBC requirements need to be set at adequate and optimal level

because if otherwise, it will have no effect on insolvencies while setting it

too high will affect financially sound insurers. Bank Negara Malaysia fixed

the minimum supervisory Capital Adequacy Ratio at 130%, which for

conventional insurer stood at 220.7% in 2013 (The Star, 2014).

4.2 The Formula Should Cover Major Risks

Under this objective, the Risk Based Capital formula should cover all major

types of risk and accurately measured. The formula should also be sensitive

to all segments of the insurance industry. The major types of risk include

market, credit, operation, underwriting, catastrophe risks, liquidity and

business or strategic. (Holzmüller, 2009).

The Malaysian Risk Based Capital is a one-size-fits-all framework that is

applicable to all insurers, whether they are Takaful operators or reinsurers.

There is no mutual and classification between small and large insurers in the

Malaysian insurance industry. The framework only covers the first three

risks stated above with interest rate (profit rate for Takaful operators) and

currency risk included in market risk. However, the framework does include

liability risk, which accounts for claims under-estimation and fluctuation of

experience (Rejda, 2011). In terms of risk sensitive, Malaysian Risk Based

Capital factor-based charges takes into account the level of risk for each

business written. This statement is validated together with the first objective.

Thus, Malaysian Risk Based Capital partly fulfils the objective in terms of

risk sensitiveness.

4.3 The Formula Should Be Proportioned to Major Risks

This objective emphasises on the importance of each type of risk in

determining the risk of insolvency. The Malaysian Risk Based Capital

assumes that each individual risk (capital charge) is independent and

disregards correlation and covariance terms. According to Butsic (1993), not

all risks occur simultaneously and when risk is not dependent, this would

lead to under-estimation of capital. The formula surrounding the Malaysian


Risk Based Capital for total capital required is straight forward; a summation

of all risk charges with no individual weight is given to each individual risk.

For time horizon, all general insurance and Takaful policies are effective in

one year, thus facing a short term risk. The long term risk exists when there

are cases of incurred but not reported claims and dispute in claim settlement

(De Ceuster, Flanagan, Hodgson, & Tahir, 2003).

Similar to US Risk Based Capital, Malaysian Risk Based Capital does

not operate in stochastic nature where there is no capital requirement

calibration (Holzmüller, 2009). The Value-at-Risk stress testing is only

applicable to evaluate the liability risk at 75% confidence level. Therefore,

Malaysian Risk Based Capital fails to fulfil this objective due to imbalance

weights for each major capital charge.

4.4 Able to Identify Highest Insolvency Costs Company Another objective of Risk Based Capital is to minimise insolvency costs and

this can be achieved by focusing on the financial health of large insurers that

would be expected to post the greatest financial instability. Malaysian Risk

Based Capital framework targets large insurers where the formula depends

on the size of the company. Lazam, Tafri, and Shahruddin (2012) and

Jaaman, Ismail, and Majid (2007) explain the elements of Tier 1 and Tier 2

in deriving the Total Capital Available (TCA). In short, TCA is the excess

of assets and liabilities and assets represent the size of the company (De Haan

& Kakes, 2010; Pasiouras & Gaganis, 2013; Pitselis, 2009).

However, the main part of this objective which is the identification of

high expected insolvency case requires further analysis since there is no

empirical research on the effectiveness of Malaysian RBC.

4.5 The Formula Should Reflect the Economic Value

The economic value of assets can be defined as the ability to pay while

liabilities are the actual amount that has to be paid. The difference between

these two is the economic value of an insurer’s net worth, which can differ

significantly from the statutory or accounting calculation of a company’s net

worth (Cummins & Lamm-Tennant, 1994). The valuation of asset and

liabilities are based on market value, wherever possible. The Signing

Authority of the insurance company is given the permission to use the best

estimate of value.

Malaysian Risk Based Capital fulfils this objective as both general

insurers and Takaful operators are bound to the approved accounting

standard set by Malaysian Accounting Standard (MASB) to value assets and

liabilities. On the other hand, similar to Swiss Solvency Test, the calculation


of Capital Adequacy Ratio is based on a statutory balance sheet in which data

does not follow market movements (Holzmüller, 2009).

4.6 The System Should Discourage Misreporting

An insurance company might manipulate financial results to avoid stern

action from a regulatory body. This is the result of having a poorly designed

Risk Based Capital framework, which can affect the capital requirement and

also policyholder’s security. Bank Negara Malaysia makes it mandatory for

an insurance company to report on details of the estimation of Capital

Adequacy Ratio together with each capital charge, and penalty will be

imposed on any misreporting. Currently, there is no case of misreporting

being recorded, thus, this objective is fulfilled.

4.7 The Formula Should Avoid Complexity

In order to have the best possible accuracy, the formula of Risk Based Capital

should be as simple as possible, as increased level of complexity will cause

an increase in premium by an insurance company (Van Rossum, 2005). In

addition, if the formula is too complex, the fulfilment of the regulation will

be more theoretical than empirical.

Even though the Malaysian Risk Based Capital formula is

straightforward, the estimation of underlying capital charges is quite

complicated. For instance, the calculation of credit risk comprises debt

obligation and asset default, where a different set of estimation of credit risk

is mitigated using collateral, guarantees and secured properties. Nonetheless,

the formula is relatively simple, but the accuracy of the risk measurement is

still in question. Based on these findings, Malaysian Risk Based Capital

partly fulfils the last objective.

4.8 Adequacy in Economic Crisis and Anticipation of Systematic Risk

Holzmüller (2009) emphasises the need to include systematic risks and

adequacy of Risk Based Capital during economic crisis due to increase in

securitisation and globalization of the insurance industry. The development

of an internal model as a tool to estimate the risk-based capital adequacy

would reduce the impact of external shocks. This is one of the sources of

systematic risks. Nebel (2004) agrees the application of various models

would reduce systematic risks.

Since the RBC formula for a conventional and Takaful company is the

same whereby one-size-fits-all, it does not satisfy Objective 8 as it may

expose the insurer to systematic risks.


4.9 Assessment of Management

In order to satisfy Objective 9, a solvency system should not rely solely on

quantitative assessment, but also on the full casual chain of insurance failure,

such as an experienced management team, early warning indicators and a

sound business plan (Ashby, Sharma, & McDonnell, 2003).

Similar to Swiss Solvency System, Malaysian Risk Based Capital fulfils

this objective through its Insurance Act (1996) and Takaful Act (1984) where

the insurance company must appoint “fit and proper” managers and

executives to warrant a sound business practice. Furthermore, the details of

qualitative requirements and rules of supervision are provided.

4.10 Flexibility of Framework over Time

Bank Negara Malaysia issued the first draft of Malaysia Risk Based Capital

for Conventional insurer in 2006 and it took three years for the system to be

implemented. It has been six years since the Risk Based Capital framework

took effect while Takaful Risk Based Capital was enforced on January 1,

2014. Solvency I has been in effect for nearly thirty years (Dickinson, 1997)

while US Risk Based Capital for more than twenty years (Eling &

Holzmüller, 2008). It is compelling to see that the system is flexible enough

towards changes and does not require a lengthy bureaucratic procedure for

reforms.

Malaysian Risk Based Capital is applicable to insurance, reinsurance and

Takaful operators that operate within the Malaysia region. However, the

Malaysian RBC faces inflexibility due to interest of multiple stakeholders on

the reformation of the solvency system. Therefore, Objective 10 is not

fulfilled.

4.11 Strengthening of Risk Management and Market Transparency

The final objective is to evaluate whether Bank Negara Malaysia is effective

in strengthening risk management and increasing market transparency. This

touches on qualitative aspects of the solvency system where transparency is

the main focus. Due to market transparency, regulator will enforce little

regulation and promote appropriate insurer behaviour (Eling, Schmeiser, &

Schmit, 2007). Malaysian Risk Based Capital has no provision for assessing

the risk management of insurance companies. Furthermore, there is no

transparency or public disclosure as the result of Capital Adequacy Ratio for

each insurance company is confidential. Thus, Malaysian Risk Based Capital

fails to meet the last objective.


5. Discussion and Policy Implications

The Malaysian Risk Based Capital framework was introduced in 2009 and

2014 for conventional insurers and Takaful operators respectively. The

limited research on Malaysian Risk Based Capital makes this study a

contribution in this area. Based on Cummins et al. (1993) paper titled “An

Economic Overview of Risk-Based Capital Requirements for Property-

Liability Insurance Industry”, this paper aims to evaluate Malaysian Risk

Based Capital for general insurer and Takaful operators against seven

objectives. The Risk Based Capital framework is further assessed against

four additional objectives developed by Holzmüller (2009).

It can be stated that Malaysian Risk-Based Capital fulfils Objective 1, 5,

6, 9; partly fulfils Objective 2, 4, 7 and does not fulfil Objective 3, 8, 10 and

11. This allows the increase of capital requirement based on the increase in

exposure to risk, even though it does not fully cover all major types of risk.

The framework also applies market valuation of assets and liabilities

according to internationally accepted accounting standards. In terms of

qualitative measure, the Malaysian regulatory body imposes a heavy penalty

for misreporting although there is no public disclosure requirement. Table 1

summarises the analysis related to Malaysian Risk Based Capital. A “double

tick” indicates that the objective is “fully satisfied”; a “tick” indicates “partly

satisfied”; a “cross” indicates “not satisfied”. Some recommendations to

improve the weaknesses identified in each criterion are also highlighted.

Table 1: Summary of the analysis

Objective Indicator Assessment of

Malaysian RBC

Recommendation to

improve

1. Provides incentive

for weak

companies.

√√

Each capital charge

allows the increase

of capital

requirement based

on the increase in

exposure of risk.

Nil.

2. The formula should

cover major risks.

√

- One-size-fits-all.

- Only covers

market, credit,

operational and

liability risk

charges.

To include other

major types of risks

such as catastrophe

and liquidity risks.


Table 1: (Continued)


be proportioned to

major risks.

X

- No covariance

adjustment.

- No individual

weight to each risk

charges.

- Value at risk

applies on liability

risk only.

Each individual risk

is aggregated against

some standards with

possible correlations.

4. Able to identify

highest insolvency

costs company.

√

- RBC target large

insurers depending

on the size of their

assets.

- No evidence of

effectiveness.

Empirical analysis on

the effectiveness of

RBC to identify high

insolvency exposure.


reflect the

economic value.

√√

Value assets and

liabilities based on

market value

approach.

Nil.

6. The system should

discourage

misreporting.

√√

Mandatory for

reporting

documents.

Nil.


avoid complexity.

√

- Formula is

straightforward but

underlying

estimation is

complicated.

- Accuracy still in

question.

Increase accuracy by

appropriate

aggregation of risks.

8. Adequacy in

economic crisis

and systematic risk.

X

All insurers/

Takaful operators

use the same model

may lead to

systematic risk

- Shifting from

formula-based to

principle-based (e.g.

Solvency II).

- Internal model to

reduce systematic

risk.

9. Assessment of

management.

√√

Appoint “fit &

proper” managers

& executives to

ensure sound

business practices.

Nil.


Table 1: (Continued)

10. Flexibility of

framework over

time.

X

Due to slowness of

legislation process

and apply rules-

based approach.

Shift to principles-

based approach

which has flexibility.

11. Strengthening of

risk management

and market

transparency.

X

- Formulation

approach as similar

to US RBC.

- No market

transparency.

Encourage insurers to

develop internal

models for their risk

management.

Notes: √√-Fully satisfied, √-Partly satisfied, X-Not satisfied.

Source: Holzmuller (2009).

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